Earnings, to trade or not to trade? Part 1

We are currently in earnings session and over the past few weeks, earnings news streaming in everyday and those who trades earnings should enjoy adrenaline rush. What if you have bought a Put (betting the stock price down) on Google shares? You should be laughing to the bank. What if you have bought a Call instead? You may have lose all your premium paid!
Is earnings predictable? Shall we trade earnings? How can we trade earnings? What is option trader’s advantage as oppose to a stock trader? If we are right, how much will we make? If we are wrong, how much will we lose?

Many questions pop up! First thing first, trading earnings to me is a game of chance, it is a betting. If it is a betting, shall we just ignore or avoid earnings? My answer to this is it depends. It is fun to add this spice into our trading plan every quarter if you can detach your emotion in trading earnings. However if you can’t take the lose (which should always happen), then you should not read further 🙂

After earning news is announced, there are basically 4 main directions the stock price can move.

1. Stock gaps up exceed market maker’s expectation.

2. Stock gaps down exceed market maker’s expectation.

3. Stock gaps up below market maker’s expectation.

4. Stock gaps down above market maker’s expectation.

Before I move on, what is market maker’s expectation? As an option trader, we can get this info by looking at the price of straddle of the shortest options tenures. It sounds complicated but in fact it is not, let’s look at the screenshot below:

AAPL is trading at $104.65, the nearest strike should be 105. Buying 105 straddle means buying 105 call that costs us $2.21 and buying 105 put that costs us $2.53 simultaneously. The total cost of buying a straddle is $4.74. This also indicate market maker’s expected stock price movement. Let’s put this info into the 4 scenarios that I mentioned above.

Before the earning news release, AAPL is trading at $104.65 with expected move $4.74. The range of the expected move is $99.91 – $109.39.

After the earning news release:

Scenario #1: AAPL gaps up above $109.39

Scenario #2: AAPL gaps down below $99.91

Scenario #3: AAPL gaps up below $109.39

Scenario #4: AAPL gaps down above $99.91

Scenario 3 and 4 can combine to become one scenario (let’s call it scenario 3.5), AAPL moves within the market marker’s expected range:

Scenario #3.5: AAPL moves within $99.91-$109.39

Now, base on this information, there are at least 4 trading ideas can be considered.

Trading idea #1: If your bet is on scenario #1 OR #2, you expect AAPL to gap a lot but you are unsure of the direction, you can buy a straddle (buy a put and a call).

Trading idea #2: If your bet is on scenario #3.5, you expect AAPL moves within the range, you can sell a straddle (sell a call and a put).

Trading idea #3: If your bet is on scenario #1, you can just buy a call. This is a more aggressive strategy but because you only buy a call, you only pay $2.21, you will start to make money if AAPL gaps up above $106.86.

Trading idea #4: If your bet is on scenario #2, you can just buy a put. This is also a more aggressive strategy but because you only buy a put, you only pay $2.53, you will start to make money if AAPL gaps down below $102.12.

Trading earnings can be fun but you should only use a small % of your fund to trade earnings. When we deploy options buying strategy in trading earnings, there is a chance of making multi bagger in a day! However the bet needs to be right. If we deploy options selling strategy (e.g. Trading idea #2), theoretically we may incur unlimited loses. Statistically, the chances of stock moves within the market maker’s expected move is higher but my preference is still to pick stock to trade Trading idea #1.

In my next post, I will discuss other advance strategies that we can use to trade earnings such as buying/selling strangles, double diagonal etc! I may also discuss some Greek concept like volatility crashes post earnings etc!